Protecting intellectual capital in mergers and acquisitions

January 2015 | PROFESSIONAL INSIGHT | MERGERS & ACQUISITIONS

Financier Worldwide Magazine

January 2015 Issue

In virtually every merger or acquisition, one of the most critical issues is the quality, stability and depth of the target’s management. For financial buyers, it is undoubtedly the most critical component because financial buyers, by definition, do not possess the expertise and experience required to run the business being acquired. Even for strategic buyers, quality of management is an essential ingredient, because what has worked for the target in the past to make it an attractive acquisition prospect is often essential for its future success and the return on investment that the buyer (and its investors) desires.

Many buyers believe that the best way to forge strong relationships with the target’s key personnel is with employment agreements that include tantalising promises of fabulous bonuses and other economic incentives. However, notwithstanding higher salaries, large bonuses and other incentives such as car allowances, extensive vacation pay, country club dues, severance terms and cell phone packages, just to name a few, the general rule still applies. Namely, in most acquisitions, existing management will not stick around for the long-term and many of them depart in three years or less. Sometimes it is a lot less. The result is that for many buyers the intellectual capital they had hoped to secure and apply for future growth evaporates much sooner than they anticipated.

Private equity groups, in particular, have learned this lesson well. They deal with the subject in a variety of ways, but one of the most useful strategies calls for the buyer to adopt a management incentive plan that rewards management for performance by offering them profits interests, also called carried interests, in the target company.

Incentive plans are as varied and complex as creative lawyers can devise, especially with regard to the tax consequences that both the recipients and the company will realise. The essential elements of such a plan include: (i) offering awards of incentive units or shares to selected management that are either fully vested upon issuance or that vest over time; (ii) providing for monetisation (payment) upon the occurrence of a future event such as a sale of the company, initial public offering, or similar type of transaction; (iii) providing some mechanism for repurchase or forfeiture if the recipient leaves the company; and (iv) including (or not) the right to receive ongoing distributions of profits. One of the advantages of this type of plan is that it is very flexible; it can be tailored to fit the specific needs or desires of the buyer. The units or shares issued under these plans are often called ‘profits interests’ or ‘carried interests’ because their future value depends upon future profitability and are ‘carried’ forward until a liquidity event occurs.

A discussion of the tax consequences of awards made under this type of plan is beyond the scope of this brief article. One salient point to consider, however, is that under current US tax law, the tax consequences are generally triggered when the award is monetised, and the quality of the gain recognised by the recipient depends upon the character of the gain to the company. In general, this means that these awards generate capital gains tax consequences for the recipients as opposed to ordinary income tax consequences, which would be the case if these interests were treated as compensation (and with the company getting a corresponding tax deduction for compensation paid). Note that the taxation of carried interests is currently the subject of much debate in the US Congress. There have been calls for repeal of the tax benefits currently realised with carried interests, but as of this writing, the law remains unchanged.

In deciding what type of management incentive plan to adopt, a buyer must consider a number of critical issues.

First and foremost, how much equity is the buyer willing to make available to the target’s management? This is a question that has a number of layers, but at the core of them all is how much dilution the other equity holders will be willing to accept. In some cases, new cash investors and lenders that hold warrants or other convertible securities may not be willing to accept any dilution and thus the entire burden of the dilutive effects of the plan will fall on the buyer. For this reason, we typically see the aggregate percent of units or shares available for issuance under these plans fall within a fairly narrow range of between 5 and 10 percent of the outstanding units or shares. Other issues include whether the interests will be fully vested upon issuance or vest over time (usually three to five years). The longer the vesting period, the less the incentive aspect of the plan will appear to offer. Also, what happens if a recipient dies, becomes disabled or leaves the company? Does it matter whether the recipient is terminated or resigns? What are the repurchase rights, if any, if any of these events occur? Should a recipient forfeit or lose his or her interests if he or she is terminated for cause?

Another issue relates to voting rights. Does the buyer want to grant voting rights to the recipients (at least as to vested interests)? While one might expect the answer to this simple question to be an equally simple ‘yes’, this is not always the case.

Also, should the recipient be entitled to distributions from the company on an ongoing basis or should the recipient only get rewarded economically when the interest is monetised?

Finally, what ‘liquidity events’ precipitate monetisation of the interest? Some might appear obvious, such as a sale or merger of the company or a sale of substantially all of its assets. But what about a recipient’s retirement? Furthermore, does a change of control trigger monetisation?

These are just a sample of the more important issues that a careful buyer must consider in adopting an effective management incentive plan.

As a general rule, a smart buyer recognises that the glow of a new owner fades rather quickly and the enticing prospect of exponential growth is often elusive. Nevertheless, buyers should be very cognisant of their need to find ways to retain and preserve the intellectual capital of the target’s management for the simple reason that by failing to do so, the buyer places in jeopardy the very heart of the transaction it has worked so hard to complete.

Lawrence M. Gold is a shareholder at Carlton Fields Jorden Burt, P.A. He can be contacted on +1 (404) 815 3396 or by email: Imgold@cfjblaw.com.